El-Erian: Unfortunately, the Cyprus Crisis Is Not Yet Over

Draconian capital controls have restored a sense of calm to a disorderly situation in Cyprus. At best, this is a short reprieve. If not followed by more fundamental (and inevitably controversial) decisions, it will just be a matter of weeks before the controls go from being a temporary solution to becoming part of an even deeper problem.

Working with European officials and the International Monetary Fund, Cyprus briefly re-opened its banks last week after imposing a large levy on uninsured deposits and onerous banking restrictions.

From check writing to cash withdrawals, account holders' access and use of funds are now very heavily constrained.

The immediate goal is to limit deposit outflows, thereby reducing the risk of a bank run that would push the country into depression and potentially threaten the functioning of the euro zone.

History tells us that this approach only works if controls are followed by a re-alignment of economic incentives and by offering the population a genuine hope for recovery and return to normalcy. Otherwise, what is viewed initially as a "circuit breaker" ends up making the underlying situation worse.

In the case of Cyprus, the current set of controls will choke off what little remains in terms of growth momentum and job creation:

• With diminished access to bank deposits, household consumption plummets and saving rates are forced higher in a dramatic fashion;

• Investment activity comes to a standstill given the enormous disruptions to aggregate demand;

• The little flow of capital that occurs is reduced to one direction – out of Cyprus; and

• With a portion of companies' working capital trapped, even more routine corporate activities are curbed.

As meaningful as all this is, we are just talking about the immediate impact. Longer-term, Cyprus has to find a new growth model to compensate for the dismantling of one based on its prior (and now discredited) status as an offshore financial center.

It will take time to come up with the replacement mix of agriculture, tourism and light manufacturing – especially for a country that experienced a significant loss in economic competitiveness (another consequence of having opted for a finance-dependent model); and that currently relies on an internal devaluation to restore factor productivity.

Cyprus can hope that its tragic situation will unlock more generous funding from the "Troika" of the European Commission, the European Central Bank and the IMF. Indeed, given recent developments, including the badly bungled initial rescue of two weeks ago, the Troika's estimate of the country's funding gap (and its related commitment to a partial financing of EUR 10 billion) is already obsolete.

Cyprus needs much more funding from the Troika; and mostly as grants (rather than loans) given the sharp deterioration in creditworthiness and growth prospects.

Political realities and internal coordination challenges render this hard, though not totally impossible.

Yet the "Icelandic alternative," including in the case of Cyprus a euro zone exit and the use of a nominal exchange rate devaluation as part of the adjustment process, seems equally unpalatable to Europe given contagion worries: Even if the spillover were to be limited to other "small non-systemic" cases (as opposed to Italy and Spain), a growing number of such cases could constitute a systemic threat.

(Read More: Cyprus Central Bank Seeks to Allay Fears)

Pending a decision among two unpleasant options, all eyes will turn to the ECB in the hope that it can come up with prolonged bridging operations. Here, again, the options are limited.

The ECB could well inject massive liquidity through the use of the ELA mechanism that has already been deployed in Greece and Ireland. This alternative way to get lots of financing into a country that has become a ward of the European state is less visible and does not require parliamentary approvals.

In doing so, the central bank would accept highly dubious collateral from Cyprus. It would also need to get the Troika to sign off on the issuance of more government debt.

Wherever they look, Cyprus and its European partners are running out of easy options. Rather than seek additional short-term palliatives, they would be well advised to invert the operational logic:

Start with what would restore growth and jobs in Cyprus over the medium term and then work back from there to what constitutes the least painful initial steps on this road.

Mohamed El-Erian is the CEO and Co-CIO of Pimco, which oversees nearly $1.8 trillion in assets and runs the Pimco Total Return Fund, the largest bond fund in the world. His book, "When Markets Collide, " was a New York Times and Wall Street Journal bestseller, won the Financial Times/Goldman Sachs 2008 Business Book of the Year, and was named a book of the year by The Economist and one of the best business books of all time by the Independent (U.K.).

(Correction: An earlier version of this story incorrectly said the partial financing was EUR 10 million, instead of the correct figure, EUR 10 billion.)